On February 10, 2005, the staff of the SEC Division of Market Regulation issued a no-action letter to the Securities Industry Association extending its earlier no-action position allowing broker-dealers to rely on registered investment advisers to meet customer identification program requirements for shared customers, even though such advisers are not yet subject to an anti-money laundering program rule. The earlier no-action relief was due to expire on February 12, 2005.
Paragraph (b)(6) of the customer identification rule adopted jointly by the Department of the Treasury and the SEC under the USA Patriot Act (the “CIP Rule”) permits broker-dealers to rely on certain other financial institutions to comply with the required elements of the rule for shared customers if, among other things, the other financial institution is subject to an anti-money laundering program rule. Since advisers currently are not subject to an anti-money laundering program rule, they do not meet this condition. Although the Department of the Treasury proposed a rule in May of 2003 requiring certain investment advisers to establish anti-money laundering programs, the rule has not yet been adopted.

The no-action letter reiterates its previous no-action position that a broker-dealer may rely on an adviser in undertaking the requirements of the CIP Rule with regard to shared customers, provided that the following requirements and conditions in paragraph (b)(6) of the CIP Rule are met:

• such reliance is reasonable under the circumstances;
• the adviser is regulated by a federal functional regulator; and
• the adviser enters into a contract requiring it to certify annually to the broker-dealer that it has implemented an anti-money laundering program, and that it (or its agent) will perform specified requirements of the broker-dealer’s customer identification program.

The relief provided by the former no-action letter and extended by the newly issued letter will be withdrawn without further action on the earlier of: (1) the date upon which the anti-money laundering program rule for advisers becomes effective; or (2) July 12, 2006.

Securities Industry Association, SEC No-Action Letter, February 10, 2005

• whether withdrawal of Interpretation No. 10 would have any adverse impact on institutional customers, such as registered investment companies, or their ability to participate in the futures market;
  
• whether there are any legal or prudential considerations that support the use by institutional customers of third-party custodial accounts in effecting futures transactions;
  
• the costs and expenses incurred by FCMs, including financing and potential opportunity costs, in connection with maintaining third-party accounts relative to regular customer accounts; and
  
• whether a six-month transition period would be sufficient for FCMs and banks to make the necessary adjustments in existing third-party custodial arrangements if the Division withdraws Interpretation No. 10.

Comments on the proposal are due by April 4, 2005.

Investment Company Institute Memorandum No. 18550 (February 16, 2005).

On February 16, 2005, the NASD charged the distributor of a large mutual fund complex with improperly rewarding and encouraging broker dealers that sold its product. The NASD alleged that the distributor violated the NASD's anti-reciprocal rule by directing approximately $100 million in brokerage commissions over a three-year period to about 50 brokerage firms that were top sellers of the funds that it distributes.

Specifically, the NASD alleged that the distributor:

• using a formula based on brokerage firms’ prior-year fund sales, calculated “target commissions” that it intended to direct to each of the top-selling retailers of the funds;
• told each brokerage firm the specific amount of that concern's target commissions for the upcoming year and discussed with the top-selling brokerage firms the benefits that the distributor expected to receive as a result of the arrangements, such as “preferred fund” or “recommended fund” status and enhanced access to a firm's sales forces; and
• provided a chart to the trading desk at the distributor's parent company (which also is the investment adviser to the funds) listing each of the top-selling brokerage firms and the amount of target commissions for each firm. The trading desk then allegedly directed brokerage commissions on fund portfolio transactions to the brokerage firms listed on the chart.

The NASD stated that the trades, which allegedly were compensation for past sales and to ensure preferential future treatment, violated the NASD’s anti-reciprocal rule. The anti-reciprocal rule is designed to prevent “quid pro quo arrangements” in which a fund’s brokerage commissions are used to compensate brokerage firms for selling the fund’s shares. The NASD stated that these commissions come from the assets of a mutual fund's shareholders.

The NASD’s prior regulatory actions regarding directed brokerage arrangements have focused more on retail firms that received directed brokerage payments from mutual fund companies in exchange for giving preferential treatment to their funds, rather than on fund companies offering to make such payments.

The Independent Directors Council issued a report addressing the new requirement in the SEC’s most recent governance rules that all boards perform annual self-assessments. The report, which was prepared by an 11-member task force of mutual fund directors, is intended to provide guidance to mutual boards implementing the requirement. It outlines issues that boards should consider, including how to conduct a self-assessment and what topics should be included in a self-assessment.

 
A copy of the report, entitled “Board Self-Assessments: Seeking to Improve Mutual Fund Board Effectiveness,” is may be found at www.idcl.org.

Paul F. Roye, Director of the SEC’s Division of Investment Management, announced today that he intends to leave the SEC in the coming weeks. Mr. Roye plans to pursue opportunities in the private sector. Mr. Roye became the Director of the Division of Investment Management in 1998. Before becoming Director of the Division of Investment Management, Mr. Roye was with a law firm, which he joined in 1982 and before that, began his career in the Division of Investment Management where he worked from 1979 to 1982.

SEC Press Release 2005-18 (February 18, 2005)

• Rule 3110(f)(1) was amended to require that any pre-dispute arbitration clause be highlighted, and preceded by the following language, which also is required to be highlighted:

“This agreement contains a predispute arbitration clause. By signing an arbitration agreement, the parties agree as follows

1. All parties to this agreement are giving up the right to sue each other in court, including the right to a trial by jury, except as provided by the rules of the arbitration forum in which a claim is filed.
2. Arbitration awards are generally final and binding; a party’s ability to have a court reverse or modify an arbitration award in is very limited.
3. The ability of the parties to obtain documents, witness statements, and other discovery is generally more limited in arbitration than in court proceedings,
4. The arbitrators do not have to explain the reason(s) for their award.
5. The panel of arbitrators will typically include a minority of arbitrators who were or are affiliated with the securities industry.
6. The rules of some arbitration forums may impose time limits for bringing a claim in arbitration. In some cases, a claim that is ineligible for arbitration may be brought in court.
7. The rules of the arbitration forum in which the claim is filed, and any amendments thereto, shall be incorporated into this agreement.”

• New Rule 3110(f)(2)(B) clarifies that if an agreement contains a predispute arbitration clause, a copy of the agreement must be to the customer, and the customer must acknowledge receipt of the agreement at the time the agreement is signed. The acknowledgement of receipt may be in the document itself, or on a separate document.
• Rule 3110(f)(3) has been amended to require that members must provide a customer with a copy of any predispute arbitration agreement or customer agreement that the customer has signed, inform the customer if it does not have a copy of an agreement, within ten business days of receiving the customer’s request. The firm also must provide the customer with the names of, and information on how to contact or obtain the rules of, all arbitration forums in which a claim may be filed under the agreement.
• Rule 3110(f)(4)(A) was amended to expressly prohibit any predispute arbitration agreements from including any condition that would:

1. Limit or contradict the rules of any SRO;
2. Limit the ability of a party to file any claim in arbitration;
3. Limit the ability of a party to file any claim in court that could otherwise be filed in court under the rules of the forum(s) in which a claim may be filed under the agreement; or
4. Limit the ability of arbitrators to make any award.

Predispute Arbitration Agreements, NASD Notice to Members 05-09 (January 2005).

A group of fund shareholders filed a class action complaint against the funds’ investment advisers alleging that the advisers had breached their fiduciary duty by implementing a scheme in which the funds would issue rights to their common shareholders, in violation of Section 36(a) of the Investment Company Act. In granting the defendant’s Motion to Dismiss, the United States District Court of the Eastern District of New York held that there is no private cause of action under Section 36(a) of the Investment Company Act.

Chamberlain v. Potapchuk, 02 CV 5870 (SJ) (EDNY 2005).

On February 3, 2005, the SEC announced that it has adopted new Rule 401 to Regulation S-T to establish a program to permit registrants, in connection with reports filed under the Securities Exchange Act of 1934 or Investment Company Act of 1940 to voluntarily file supplemental tagged financial information in certain specified EDGAR filings using the eXtensible Business Reporting Language (“XBRL”) format. Registrants choosing to participate in the voluntary program would continue to file their financial information in HTML or ASCII format, as currently required. The voluntary program is intended to help the SEC evaluate the usefulness of data tagging in general, and XBRL in particular, to registrants, investors, the Commission and the marketplace generally. The new rules go into effect on March 16, 2005.

XBRL Voluntary Reporting Program on the EDGAR System, Investment Company Act Release No. 26747 (February 3, 2005).

• Bermuda law and the trust deed conferred no power on the unitholders to vote on the election or removal of the trustee or investment manager or to exercise control over the trust;
  
• The registered fund and certain private funds managed by the same investment adviser will not be the only investors in the trust, and neither will contribute the bulk of the assets of a trust;
  
• A third party investment manager unaffiliated with the fund’s investment adviser is solely responsible for the selection and compensation of the subadvisers of the trust;
  
• The trusts has directors, and no entity performs functions similar to that of a director except the third party investment manager, subadvisers, and the trustee of the trust;
  
• If the registered fund or private funds were dissatisfied with the management of the trust, their only remedy would be to redeem their interest in the trust; and
  
• The registered fund’s investment in the trust will be on terms that are substantially the same and no less advantageous than the private funds’ investments in the trust.

Wells Fargo Alternative Asset Management, LLC, SEC No-Action Letter (avail. Jan. 26, 2005).

• Modify the provision regarding occasional gifts of meals, sports, entertainment tickets, by requiring that broker-dealer personnel attend such meals, entertainment events, and business functions and expressly stating that such gifts must not call into question the dealer’s ethical standards;
  
• Incorporate definitions of “non-cash compensation,” “cash compensation,” and “offeror” based on language in NASD Rules 2710, 2820, and 2830 and expansion of the definition of offeror to include, with respect to securities held as assets underlying municipal fund securities, any person considered an offeror under relevant NASD rules;
  
• Treat non-cash sales incentives relating to municipal fund securities and other primary offerings of municipal securities (i.e., bonds and notes) in a manner similar to NASD’s treatment of non-cash sales incentives relating to mutual funds, variable contracts, and corporate debt and equity offerings. Among other things, the rule would permit gifts that do not exceed $100 per individual per year and are not preconditioned on achievement of a sales target, and the gift or receipt of occasional gifts of meals or tickets to theatrical, sporting and other entertainment, but only if such occasional gifts are not preconditioned on achievement of a sales target;
  
• Limit the circumstances under which broker-dealers or offerors may pay or reimburse costs of training or education, based on NASD rules, such as by requiring that attendance at, and payment for, such meetings is not preconditioned on achievement of a sales target, reimbursement is not applied to expenses of associated persons’ guests, and meetings be held at appropriate locations;
  
• Require that non-cash compensation arrangements include the total production and equal weighting requirements used under NASD rules, so that the arrangement does not favor sales of one municipal security over another; and
  
• Amend the recordkeeping requirements in Rule G-8 to require broker-dealers to maintain certain records relating to non-cash compensation and internal sales incentive programs.

The MSRB Notice states explicitly that it intends generally that the provisions of Rule G-20 be read consistently with the analogous NASD provisions, unless the MSRB specifically indicates otherwise. The MSRB stated that relevant NASD interpretations would be presumed to apply to MSRB rule provisions, subject to the MSRB’s making distinctions needed in the context of municipal fund securities and other primary offerings of municipal securities.

Notice of Filing of Proposed Rule Change Relating to Amendments to Rule G-20, on Gifts and Gratuities, and Rule G-8, on Recordkeeping, MSRB Notice 2005-05 (January 13, 2005).

The SEC announced that it has settled two lawsuits brought against investment banks relating to the firms’ allocation of securities issued in initial public offerings to institutional customers. The SEC alleged that the firms had violated Rule 101 of Regulation M under the Securities Exchange Act of 1934 by inducing and attempting to induce customers who received IPO allocations to purchase additional shares in the aftermarket during the restricted period (i.e., before the firms had completed their participation in the IPOs). Under the terms of the settlements, each firm will be enjoined from violating Rule 101 of Regulation M and required to pay a $40 million civil penalty. Neither firm admitted or denied the allegations in the SEC’s complaints, and the settlement terms are subject to court approval.

Rule 101 of Regulation M prohibits underwriters, during a restricted period prior to the completion of their participation in the distribution of IPO shares, from bidding for, purchasing, or attempting to induce any person to bid for or purchase any offered security in the aftermarket. The rule is intended to prevent activities that could artificially influence the market for the offered securities.

The SEC alleged that one firm violated Rule 101 by

• telling certain customers that they could obtain good allocations of “hot” IPOs if they expressed an interest in buying shares in the immediate aftermarket;
  
• soliciting aftermarket interest from customers that the firm knew had no interest in owning the shares for the long term, resulting in the customers flipping both their IPO allocations and aftermarket purchases;
  
• suggesting to certain customers the aftermarket price limits they should give in order to obtain a good IPO allocation;
  
• in certain cases encouraging customers to increase the aftermarket prices they originally said they would be willing to pay;
  
• accepting customers’ indications that they would purchase shares in the aftermarket interest equal to or greater than their IPO allocations (such as “1 for 1” or some other ratio); and
  
• in one case, soliciting an aftermarket order from a customer before all of the IPO shares had been distributed, which the firm executed once trading began. This customer sold both its IPO and aftermarket shares the same day.

In the other case, the SEC alleged that the firm violated Rule 101 of Regulation M by

• telling certain customers that the firm considered purchases in the immediate aftermarket to be significant in the determination of IPO allocations, telling them that the firm verified whether customers placed orders to purchase stock in the immediate aftermarket following an IPO, and asking customers during restricted periods whether, and at what prices and in what quantities, they intended to place orders to purchase IPO stock in the immediate aftermarket;
  
• encouraging certain customers that had expressed interest in buying shares in the aftermarket to increase the prices that they would pay;
  
• seeking and/or accepting aftermarket interest from customers based solely, or in relevant part, on the amount of their prospective allocations.

Securities and Exchange Commission v. Morgan Stanley & Co. Incorporated, Civil Action No. 1:05 CV00166 (HHK) (D.D.C.), Litigation Release No.19050 (Jan. 25, 2005); Securities Exchange Commission v. Goldman Sachs & Co., 05 CV 853 (SAS) (S.D.N.Y), Litigation Release No. 19051 (Jan. 25, 2005).